Saturday, August 9, 2008

Value Investors and Cockroaches

In an extremely interesting book “A demon of our Design” author Richard Bookstaber , a Wall street quant with over 20yrs of trading experience explains the behaviour of the participants in the financial markets. While the academic community craved for physics like precision and complicated mathematics in economics and finance. Mr.Bookstaber came up with an interesting biology analogue for the economic behaviour of the participants in the financial market. He wrote a paper with his fellow MIT graduate student, Joe Langsam, entitled “On the Optimality of Coarse Behavioural Rules”.
He explains that the best measure of adaptation to unanticipated risks in a biological setting is the length of time period a species has survived. One that has survived for hundreds of millions of years is considered to have a better strategy to adapt to unanticipated events than the one that has survived for short time period. A species that is prolific and burgeoning but then dies because of some unanticipated event may be considered as having a good strategy for dealing with expected events but not with the unexpected ones.
From that point a cockroach is a prime example because it has survived numerous unanticipated changes in the ecosystem – from jungles turning to deserts and facing different predators and countless other unforeseen changes. But what is extraordinary about cockroach is that it has survived all these unanticipated changes with a simple defense mechanism of moving away from slight puffs of air, puffs that might signal an approaching predator. He refers to this mechanism as a “coarse and sub-optimal behaviour”. This mechanism ignores a wide range of information and risks but still survives for a longer period of time than the other highly adaptable and sophisticated species such as furu, a perch like fish of lake Victoria in Africa which was finely tuned to its environment and developed numerous skills and evolved into a number of species each with its own special skills. however they became extinct when a Kenyan game fisheries officer introduced nile perch into the lake. Its extinction was just a result of dumb luck that someone had introduced an alien species into the lake. This situation seems similar to the LTCM debacle where the default of Russian bonds an unanticipated event became a cause of their demise.
According to Christopher Browne, Managing Director of Tweedy Browne Funds true value investors are cockroaches of the investment world with a simple strategy of eschewing leverage, staying within one’s circle of competence and eventually demanding a substantial margin of safety whereas furu is akin to today’s highly leveraged hedge fund investor seeking to eliminate risk by adjusting his portfolio with the help of numerous complicated probability models at his arsenal

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